The most celebrated of investors
says stocks can't possibly meet the public's expectations. As for the Internet?
He notes how few people got rich from two other transforming industries, auto
and aviation.

Warren Buffett, chairman of Berkshire Hathaway, almost never talks
publicly about the general level of stock prices--neither in his famed annual
report nor at Berkshire's thronged annual meetings nor in the rare speeches
he gives. But in the past few months, on four occasions, Buffett did step
up to that subject, laying out his opinions, in ways both analytical and creative,
about the long-term future for stocks. FORTUNE's Carol Loomis heard the last
of those talks, given in September to a group of Buffett's friends (of whom
she is one), and also watched a videotape of the first speech, given in July
at Allen & Co.'s Sun Valley, Idaho, bash for business leaders. From those
extemporaneous talks (the first made with the Dow Jones industrial average
at 11,194), Loomis distilled the following account of what Buffett said. Buffett
reviewed it and weighed in with some clarifications.

Investors in stocks these
days are expecting far too much, and I'm going to explain why. That will inevitably
set me to talking about the general stock market, a subject I'm usually unwilling
to discuss. But I want to make one thing clear going in: Though I will be
talking about the level of the market, I will not be predicting its next moves.
At Berkshire we focus almost exclusively on the valuations of individual companies,
looking only to a very limited extent at the valuation of the overall market.
Even then, valuing the market has nothing to do with where it's going to go
next week or next month or next year, a line of thought we never get into.
The fact is that markets behave in ways, sometimes for a very long stretch,
that are not linked to value. Sooner or later, though, value counts. So what
I am going to be saying--assuming it's correct--will have implications for
the long-term results to be realized by American stockholders.

Let's start by defining
"investing." The definition is simple but often forgotten: Investing is laying
out money now to get more money back in the future--more money in real terms,
after taking inflation into account.

Now, to get some historical
perspective, let's look back at the 34 years before this one--and here we
are going to see an almost Biblical kind of symmetry, in the sense of lean
years and fat years--to observe what happened in the stock market. Take, to
begin with, the first 17 years of the period, from the end of 1964 through
1981. Here's what took place in that interval:

Dow Jones Industrial
Average

Dec. 31, 1964: 874.12
Dec. 31, 1981: 875.00

Now I'm known as a long-term
investor and a patient guy, but that is not my idea of a big move.

And here's a major and
very opposite fact: During that same 17 years, the GDP of the U.S.--that is,
the business being done in this country--almost quintupled, rising by 370%.
Or, if we look at another measure, the sales of the FORTUNE 500 (a changing
mix of companies, of course) more than sextupled. And yet the Dow went exactly
nowhere.

To understand why that
happened, we need first to look at one of the two important variables that
affect investment results: interest rates. These act on financial valuations
the way gravity acts on matter: The higher the rate, the greater the downward
pull. That's because the rates of return that investors need from any kind
of investment are directly tied to the risk-free rate that they can earn from
government securities. So if the government rate rises, the prices of all
other investments must adjust downward, to a level that brings their expected
rates of return into line. Conversely, if government interest rates fall,
the move pushes the prices of all other investments upward. The basic proposition
is this: What an investor should pay today for a dollar to be received tomorrow
can only be determined by first looking at the risk-free interest rate.

Consequently, every time
the risk-free rate moves by one basis point--by 0.01%--the value of every
investment in the country changes. People can see this easily in the case
of bonds, whose value is normally affected only by interest rates. In the
case of equities or real estate or farms or whatever, other very important
variables are almost always at work, and that means the effect of interest
rate changes is usually obscured. Nonetheless, the effect--like the invisible
pull of gravity--is constantly there.

In the 1964-81 period,
there was a tremendous increase in the rates on long-term government bonds,
which moved from just over 4% at year-end 1964 to more than 15% by late 1981.
That rise in rates had a huge depressing effect on the value of all investments,
but the one we noticed, of course, was the price of equities. So there--in
that tripling of the gravitational pull of interest rates--lies the major
explanation of why tremendous growth in the economy was accompanied by a stock
market going nowhere.

Then, in the early
1980s, the situation reversed itself. You will remember Paul Volcker coming
in as chairman of the Fed and remember also how unpopular he was. But the
heroic things he did--his taking a two-by-four to the economy and breaking
the back of inflation--caused the interest rate trend to reverse, with some
rather spectacular results. Let's say you put $1 million into the 14% 30-year
U.S. bond issued Nov. 16, 1981, and reinvested the coupons. That is, every
time you got an interest payment, you used it to buy more of that same bond.
At the end of 1998, with long-term governments by then selling at 5%, you
would have had $8,181,219 and would have earned an annual return of more than
13%.

That 13% annual
return is better than stocks have done in a great many 17-year periods in
history--in most 17-year periods, in fact. It was a helluva result, and from
none other than a stodgy bond.

The power of interest
rates had the effect of pushing up equities as well, though other things that
we will get to pushed additionally. And so here's what equities did in that
same 17 years: If you'd invested $1 million in the Dow on Nov. 16, 1981, and
reinvested all dividends, you'd have had $19,720,112 on Dec. 31, 1998. And
your annual return would have been 19%.

The increase in
equity values since 1981 beats anything you can find in history. This increase
even surpasses what you would have realized if you'd bought stocks in 1932,
at their Depression bottom--on its lowest day, July 8, 1932, the Dow closed
at 41.22--and held them for 17 years.

The second thing
bearing on stock prices during this 17 years was after-tax corporate profits,
which the chart, After-Tax Corporate Profits as a Percentage of GDP, displays
as a percentage of GDP. In effect, what this chart tells you is what portion
of the GDP ended up every year with the shareholders of American business.

The chart, as
you will see, starts in 1929. I'm quite fond of 1929, since that's when it
all began for me. My dad was a stock salesman at the time, and after the Crash
came, in the fall, he was afraid to call anyone--all those people who'd been
burned. So he just stayed home in the afternoons. And there wasn't television
then. Soooo ... I was conceived on or about Nov. 30, 1929 (and born nine months
later, on Aug. 30, 1930), and I've forever had a kind of warm feeling about
the Crash.

As you can see,
corporate profits as a percentage of GDP peaked in 1929, and then they tanked.
The left-hand side of the chart, in fact, is filled with aberrations: not
only the Depression but also a wartime profits boom--sedated by the excess-profits
tax--and another boom after the war. But from 1951 on, the percentage settled
down pretty much to a 4% to 6.5% range.

By 1981, though,
the trend was headed toward the bottom of that band, and in 1982 profits tumbled
to 3.5%. So at that point investors were looking at two strong negatives:
Profits were sub-par and interest rates were sky-high.

And as is so typical,
investors projected out into the future what they were seeing. That's their
unshakable habit: looking into the rear-view mirror instead of through the
windshield. What they were observing, looking backward, made them very discouraged
about the country. They were projecting high interest rates, they were projecting
low profits, and they were therefore valuing the Dow at a level that was the
same as 17 years earlier, even though GDP had nearly quintupled.

Now, what happened
in the 17 years beginning with 1982? One thing that didn't happen was comparable
growth in GDP: In this second 17-year period, GDP less than tripled. But interest
rates began their descent, and after the Volcker effect wore off, profits
began to climb--not steadily, but nonetheless with real power. You can see
the profit trend in the chart, which shows that by the late 1990s, after-tax
profits as a percent of GDP were running close to 6%, which is on the upper
part of the "normalcy" band. And at the end of 1998, long-term government
interest rates had made their way down to that 5%.

These dramatic changes in the two fundamentals that matter most
to investors explain much, though not all, of the more than tenfold rise in
equity prices--the Dow went from 875 to 9,181--during this 17-year period.
What was at work also, of course, was market psychology. Once a bull market
gets under way, and once you reach the point where everybody has made money
no matter what system he or she followed, a crowd is attracted into the game
that is responding not to interest rates and profits but simply to the fact
that it seems a mistake to be out of stocks. In effect, these people superimpose
an I-can't-miss-the-party factor on top of the fundamental factors that drive
the market. Like Pavlov's dog, these "investors" learn that when the bell
rings--in this case, the one that opens the New York Stock Exchange at 9:30
a.m.--they get fed. Through this daily reinforcement, they become convinced
that there is a God and that He wants them to get rich.

Today, staring
fixedly back at the road they just traveled, most investors have rosy expectations.
A Paine Webber and Gallup Organization survey released in July shows that
the least experienced investors--those who have invested for less than five
years--expect annual returns over the next ten years of 22.6%. Even those
who have invested for more than 20 years are expecting 12.9%.

Now, I'd like
to argue that we can't come even remotely close to that 12.9%, and make my
case by examining the key value-determining factors. Today, if an investor
is to achieve juicy profits in the market over ten years or 17 or 20, one
or more of three things must happen. I'll delay talking about the last of
them for a bit, but here are the first two:

(1) Interest
rates must fall further. If government interest rates, now at a level
of about 6%, were to fall to 3%, that factor alone would come close to doubling
the value of common stocks. Incidentally, if you think interest rates are
going to do that--or fall to the 1% that Japan has experienced--you should
head for where you can really make a bundle: bond options.

(2) Corporate
profitability in relation to GDP must rise. You know, someone once
told me that New York has more lawyers than people. I think that's the same
fellow who thinks profits will become larger than GDP. When you begin to expect
the growth of a component factor to forever outpace that of the aggregate,
you get into certain mathematical problems. In my opinion, you have to be
wildly optimistic to believe that corporate profits as a percent of GDP can,
for any sustained period, hold much above 6%. One thing keeping the percentage
down will be competition, which is alive and well. In addition, there's a
public-policy point: If corporate investors, in aggregate, are going to eat
an ever-growing portion of the American economic pie, some other group will
have to settle for a smaller portion. That would justifiably raise political
problems--and in my view a major reslicing of the pie just isn't going to
happen.

So where do some
reasonable assumptions lead us? Let's say that GDP grows at an average 5%
a year--3% real growth, which is pretty darn good, plus 2% inflation. If GDP
grows at 5%, and you don't have some help from interest rates, the aggregate
value of equities is not going to grow a whole lot more. Yes, you can add
on a bit of return from dividends. But with stocks selling where they are
today, the importance of dividends to total return is way down from what it
used to be. Nor can investors expect to score because companies are busy boosting
their per-share earnings by buying in their stock. The offset here is that
the companies are just about as busy issuing new stock, both through primary
offerings and those ever present stock options.

So I come back
to my postulation of 5% growth in GDP and remind you that it is a limiting
factor in the returns you're going to get: You cannot expect to forever realize
a 12% annual increase--much less 22%--in the valuation of American business
if its profitability is growing only at 5%. The inescapable fact is that the
value of an asset, whatever its character, cannot over the long term grow
faster than its earnings do.

Now, maybe you'd
like to argue a different case. Fair enough. But give me your assumptions.
If you think the American public is going to make 12% a year in stocks, I
think you have to say, for example, "Well, that's because I expect GDP to
grow at 10% a year, dividends to add two percentage points to returns, and
interest rates to stay at a constant level." Or you've got to rearrange these
key variables in some other manner. The Tinker Bell approach--clap if you
believe--just won't cut it.

Beyond that, you
need to remember that future returns are always affected by current valuations
and give some thought to what you're getting for your money in the stock market
right now. Here are two 1998 figures for the FORTUNE 500. The companies in
this universe account for about 75% of the value of all publicly owned American
businesses, so when you look at the 500, you're really talking about America
Inc.

As we focus on
those two numbers, we need to be aware that the profits figure has its quirks.
Profits in 1998 included one very unusual item--a $16 billion bookkeeping
gain that Ford reported from its spinoff of Associates--and profits also included,
as they always do in the 500, the earnings of a few mutual companies, such
as State Farm, that do not have a market value. Additionally, one major corporate
expense, stock-option compensation costs, is not deducted from profits. On
the other hand, the profits figure has been reduced in some cases by write-offs
that probably didn't reflect economic reality and could just as well be added
back in. But leaving aside these qualifications, investors were saying on
March 15 this year that they would pay a hefty $10 trillion for the $334 billion
in profits.

Bear in mind--this
is a critical fact often ignored--that investors as a whole cannot get anything
out of their businesses except what the businesses earn. Sure, you and I can
sell each other stocks at higher and higher prices. Let's say the FORTUNE
500 was just one business and that the people in this room each owned a piece
of it. In that case, we could sit here and sell each other pieces at ever-ascending
prices. You personally might outsmart the next fellow by buying low and selling
high. But no money would leave the game when that happened: You'd simply take
out what he put in. Meanwhile, the experience of the group wouldn't have been
affected a whit, because its fate would still be tied to profits. The absolute
most that the owners of a business, in aggregate, can get out of it in the
end--between now and Judgment Day--is what that business earns over time.

And there's still
another major qualification to be considered. If you and I were trading pieces
of our business in this room, we could escape transactional costs because
there would be no brokers around to take a bite out of every trade we made.
But in the real world investors have a habit of wanting to change chairs,
or of at least getting advice as to whether they should, and that costs money--big
money. The expenses they bear--I call them frictional costs--are for a wide
range of items. There's the market maker's spread, and commissions, and sales
loads, and 12b-1 fees, and management fees, and custodial fees, and wrap fees,
and even subscriptions to financial publications. And don't brush these expenses
off as irrelevancies. If you were evaluating a piece of investment real estate,
would you not deduct management costs in figuring your return? Yes, of course--and
in exactly the same way, stock market investors who are figuring their returns
must face up to the frictional costs they bear.

And what do they
come to? My estimate is that investors in American stocks pay out well over
$100 billion a year--say, $130 billion--to move around on those chairs or
to buy advice as to whether they should! Perhaps $100 billion of that relates
to the FORTUNE 500. In other words, investors are dissipating almost a third
of everything that the FORTUNE 500 is earning for them--that $334 billion
in 1998--by handing it over to various types of chair-changing and chair-advisory
"helpers." And when that handoff is completed, the investors who own the 500
are reaping less than a $250 billion return on their $10 trillion investment.
In my view, that's slim pickings.

Perhaps by now
you're mentally quarreling with my estimate that $100 billion flows to those
"helpers." How do they charge thee? Let me count the ways. Start with transaction
costs, including commissions, the market maker's take, and the spread on underwritten
offerings: With double counting stripped out, there will this year be at least
350 billion shares of stock traded in the U.S., and I would estimate that
the transaction cost per share for each side--that is, for both the buyer
and the seller--will average 6 cents. That adds up to $42 billion.

Move on to the
additional costs: hefty charges for little guys who have wrap accounts; management
fees for big guys; and, looming very large, a raft of expenses for the holders
of domestic equity mutual funds. These funds now have assets of about $3.5
trillion, and you have to conclude that the annual cost of these to their
investors--counting management fees, sales loads, 12b-1 fees, general operating
costs--runs to at least 1%, or $35 billion.

And none of the
damage I've so far described counts the commissions and spreads on options
and futures, or the costs borne by holders of variable annuities, or the myriad
other charges that the "helpers" manage to think up. In short, $100 billion
of frictional costs for the owners of the FORTUNE 500--which is 1% of the
500's market value--looks to me not only highly defensible as an estimate,
but quite possibly on the low side.

It also looks
like a horrendous cost. I heard once about a cartoon in which a news commentator
says, "There was no trading on the New York Stock Exchange today. Everyone
was happy with what they owned." Well, if that were really the case, investors
would every year keep around $130 billion in their pockets.

Let me summarize
what I've been saying about the stock market: I think it's very hard to come
up with a persuasive case that equities will over the next 17 years perform
anything like--anything like--they've performed in the past 17. If I had to
pick the most probable return, from appreciation and dividends combined, that
investors in aggregate--repeat, aggregate--would earn in a world of constant
interest rates, 2% inflation, and those ever hurtful frictional costs, it
would be 6%. If you strip out the inflation component from this nominal return
(which you would need to do however inflation fluctuates), that's 4% in real
terms. And if 4% is wrong, I believe that the percentage is just as likely
to be less as more.

Let me come back
to what I said earlier: that there are three things that might allow investors
to realize significant profits in the market going forward. The first was
that interest rates might fall, and the second was that corporate profits
as a percent of GDP might rise dramatically. I get to the third point now:
Perhaps you are an optimist who believes that though investors as a whole
may slog along, you yourself will be a winner. That thought might be particularly
seductive in these early days of the information revolution (which I wholeheartedly
believe in). Just pick the obvious winners, your broker will tell you, and
ride the wave.

Well, I thought
it would be instructive to go back and look at a couple of industries that
transformed this country much earlier in this century: automobiles and aviation.
Take automobiles first: I have here one page, out of 70 in total, of car and
truck manufacturers that have operated in this country. At one time, there
was a Berkshire car and an Omaha car. Naturally I noticed those. But there
was also a telephone book of others.

All told, there
appear to have been at least 2,000 car makes, in an industry that had an incredible
impact on people's lives. If you had foreseen in the early days of cars how
this industry would develop, you would have said, "Here is the road to riches."
So what did we progress to by the 1990s? After corporate carnage that never
let up, we came down to three U.S. car companies--themselves no lollapaloozas
for investors. So here is an industry that had an enormous impact on America--and
also an enormous impact, though not the anticipated one, on investors.

Sometimes, incidentally,
it's much easier in these transforming events to figure out the losers. You
could have grasped the importance of the auto when it came along but still
found it hard to pick companies that would make you money. But there was one
obvious decision you could have made back then--it's better sometimes to turn
these things upside down--and that was to short horses. Frankly, I'm disappointed
that the Buffett family was not short horses through this entire period. And
we really had no excuse: Living in Nebraska, we would have found it super-easy
to borrow horses and avoid a "short squeeze."

U.S. Horse Population
1900: 21 million
1998: 5 million

The other truly
transforming business invention of the first quarter of the century, besides
the car, was the airplane--another industry whose plainly brilliant future
would have caused investors to salivate. So I went back to check out aircraft
manufacturers and found that in the 1919-39 period, there were about 300 companies,
only a handful still breathing today. Among the planes made then--we must
have been the Silicon Valley of that age--were both the Nebraska and the Omaha,
two aircraft that even the most loyal Nebraskan no longer relies upon.

Move on to failures
of airlines. Here's a list of 129 airlines that in the past 20 years filed
for bankruptcy. Continental was smart enough to make that list twice. As of
1992, in fact--though the picture would have improved since then--the money
that had been made since the dawn of aviation by all of this country's airline
companies was zero. Absolutely zero.

Sizing all this
up, I like to think that if I'd been at Kitty Hawk in 1903 when Orville Wright
took off, I would have been farsighted enough, and public-spirited enough--I
owed this to future capitalists--to shoot him down. I mean, Karl Marx couldn't
have done as much damage to capitalists as Orville did.

I won't dwell
on other glamorous businesses that dramatically changed our lives but concurrently
failed to deliver rewards to U.S. investors: the manufacture of radios and
televisions, for example. But I will draw a lesson from these businesses:
The key to investing is not assessing how much an industry is going to affect
society, or how much it will grow, but rather determining the competitive
advantage of any given company and, above all, the durability of that advantage.
The products or services that have wide, sustainable moats around them are
the ones that deliver rewards to investors.

This talk of 17-year
periods makes me think--incongruously, I admit--of 17-year locusts. What could
a current brood of these critters, scheduled to take flight in 2016, expect
to encounter? I see them entering a world in which the public is less euphoric
about stocks than it is now. Naturally, investors will be feeling disappointment--but
only because they started out expecting too much.

Grumpy or not,
they will have by then grown considerably wealthier, simply because the American
business establishment that they own will have been chugging along, increasing
its profits by 3% annually in real terms. Best of all, the rewards from this
creation of wealth will have flowed through to Americans in general, who will
be enjoying a far higher standard of living than they do today. That wouldn't
be a bad world at all--even if it doesn't measure up to what investors got
used to in the 17 years just passed.